The Role of the Exchange Rate Regime in Contributing to the 2001 Crisis in Argentina - Essay Example

The role of the exchange rate regime in contributing to the 2001 crisis in Argentina Five years before the start of the deflation that escalated in 2001 Argentina was viewed as a model to the rest of the Latin America. It experienced economic growth, while inflation was reduced and controlled. However, by 2001 peso was devalued against the dollar, output decreased significantly, government defaulted on its debt, and inflation returned (IMF 2003, p.3). Fixed exchange regime, once deemed crucial to fighting inflation, turned the country’s seeming stability into a disaster. Argentina underwent structural changes in the 1990’s. In the late 1980’s, Argentina suffered high levels of inflation. Thus, in the 1990’s, the administration of president Menem implemented several reforms to overcome the country’s macroeconomic instability through the Convertibility Plan (Rodriguez – Boetsch 2005, p.302). Inflation dropped to single digits, whereas economy remained stable (Rodriguez – Boetsch 2005, p.302). Moreover, the country underwent privatization, deregulation, and trade liberalization (Rodriguez – Boetsch 2005, p.302). Until the crisis in 1998, Argentina was viewed as a success story and a role model. The currency board was created to conquer inflation and create deflationary expectations among the general populace. As part of the Convertibility Plan, the board was created to enhance confidence among investors, population, and anyone in power to set prices in the Argentinean market (IMF 2003, p.4). To stabilize the economy, the board pegged the Argentine peso to the US dollar at 1:1 (Rodriguez – Boetsch 2005, p.307). Moreover, it linked the supply of pesos to the quantity of US dollars held in Central Bank reserves (Rodriguez – Boetsch 2005, p.307). Money supply depended on the US dollar reserves. Since the Argentinean peso was pegged 1:1 to the US dollar, the money supply was determined in the same way. For example, assume there was only one dollar in the Central Bank’s reserves. Then the money supply would be one Argentinean peso times the money multiplier. Now assume that an additional dollar is bought by the Central Bank and put in reserves. This increase in reserves translates into an increase in money supply. Namely, one additional peso is put into circulation. However, this is not the end of the analysis. In every economy, a stock of value changes hands several times within a given time period. Thus, this additional peso needs to also be multiplied by the money multiplier. This relationship is described in equation (1) below, where is money supply, is monetary base and is the money multiplier (Gokbudak 1995, p.111). (1) Money multiplier, in return, is determined by the required reserve ratio (Rodriguez – Boetsch 2005, p.308). This definition can be seen in equation (2), where is the money multiplier, and is the required reserve ratio determined by the Central Bank. (2) The board eliminated previously available options. Monetary policy was no longer an option. Under a floating regime, the central bank can sell or buy securities and so through open market operations control the interest rate, which in turn determines the cost of money and can offset inflation. Since this policy was not an option, only fiscal policy remained. The labor market also needed to become flexible in order to absorb some of the possible shocks (IMF 2003, p.8, 26). However, with 70 percent of federal budget going to social security and provinces, little maneuvering space was left for the fiscal policy (IMF 2003, p. 13). There are several causes of the crisis. The IMF (2003) considers this crisis to have been caused by the interaction between fiscal policy and the currency board arrangement. The crisis is also seen as an outgrowth of fragile balance sheets in the undeveloped banking sector and lack of political strength to implement a reform. Public sector debt is seen as a trigger which, coupled with previous history of economic slumps, led to the above causes (IMF 2003, p. 4). Following paragraphs will describe factors that led to the crisis. Prior to the crisis, Argentina seemed to grow and progress. Average real GDP growth was negative in the 1980’s (IMF 2003, p.6). The 1990’s, however, were a decade of growth for Argentina. The real GDP growth was 10 percent in the 1991 – 1992 period, and 5 percent in the 1993 – 1994 period (IMF 2003, p.6). The growth rates were rather elusive. Though initial growth rates were very high, and consumption increased, this increase was largely because of previous years of economic stagnation. The population saw a rise in income and rushed to spend it. However, though consumption levels increased, they were mostly in durables. Once the consumption needs were satisfied, that is, durables were acquired, the economy returned to the previous level (IMF 2003, p. 12). According to the IMF (2003, p.12), the growth rate potential was 3 - 3.5 percent in the 1990’s, were it not for the consumption on durables. However, concurrently to growth, the government ran a deficit and accumulated debt. In the 1992 – 1998 period, the deficit averaged to 1.5 percent of the GDP (IMF 2003, p.8). By 1998, the deficit increased to 2.75 percent of the GDP (IMF 2003, p.8). The public debt ratio increased from 31 percent of the GDP in 1992 to 41 percent in 1998 (IMF 2003, p.10). Instead of securing themselves against the time of economic downturn, Argentinean fiscal policy only deepened it. The IMF (2003) estimates that under a more prudent fiscal policy, which would not allow spending to increase as much as it was allowed in reality, Argentinean debt ratio would had actually amounted to 26 percent of GDP in 1998, instead of 41 percent (IMF 2003, p.10). Privatization could not eliminate deficit either. As mentioned at the beginning of this paper, Argentina underwent privatization. However, Rodriguez – Boetsch (2005) argue that privatization only increases corruption and inefficiency as rent – seeking is not eliminated once companies become private. Besides rent – seeking, regulatory framework in a quick privatization process lags behind economic liberalization, as does transparency (Rodriguez – Boetsch 2005, p.304). In search of profits, new firm owners laid off over 50 percent of workers, thus further burdening the federal government (Rodriguez – Boetsch 2005, p. 306). The fixed exchange rate regime curbed Argentina’s ability to use exports as a financing source. Export industry enables countries to increase GDP regardless of domestic demand slumps or other types of crisis. However, Argentinean export industry was small. According to the IMF (2003, p.18), debt-to-exports ratio amounted to 455 percent in 1998. While Argentina could had depreciated its currency to export more and so increase and diversify its sources of GDP, this option was not possible under the system Argentina had in place. Pegged exchange rate also contributed to import rates being much higher than exports. Whereas exports grew at 8 percent a year, imports grew at 25 percent (IMF 2003, p.24). Deficits grew because of an overvalued peso. By 1995, Argentina relied heavily on foreign investment. In the 1991 – 1994 period, Argentinean inflation rate was higher than the American (Rodriguez – Boetsch 2005, p.308). Argentinean export industry became less competitive on the American market. Exports stagnated and imports increased. Similar situation happened in case of Argentinean trade with Brazil and the European Union. Brazilian real was devalued in 1999, which made imports from Brazil inexpensive relative to goods produced in Argentina (Rodriguez – Boetsch 2005, p.309). Since peso was pegged against the dollar, once dollar started appreciating against the euro, so did the peso. As a result, Argentinean products were no longer attractive to the EU markets. Since the EU was Argentina’s second largest trading partner after Brazil, this development significantly affected Argentina’s economic growth (Rodriguez – Boetsch 2005, p.309). Current-account deficit of US$6.8 billion in 1996 jumped to US$14.5 billion in 1998 (Rodriguez – Boetsch 2005, p.308). To maintain balance of payments, capital inflows needed to be created (Rodriguez – Boetsch 2005, p.308). Balance of payments is a two sided identity, one being composed of trade in goods, a current account, and the other being composed of financial inflows and outflows, a capital account. Capital account is also sometimes called financial account. If the current account is in deficit, this means that financial account needs to balance it out (Pink 2004, p.13). In this case, since Argentina imported more than it exported, its currency was owned by non residents and the way to balance out the balance of payments was to increase foreign investment in Argentina. Argentinean capital became dependent on foreign investors’ mood. Events in Argentina and abroad triggered the crisis. One of the triggers was the President Menem’s attempt to stay in power for the third term, which signaled political instability to economic actors (IMF 2003, p. 38). A sharp decrease in consumption described previously, was another factor (IMF 2003, p.38). A rise in investment insecurity arising from the 1997 Asian financial crisis is also seen as a trigger, as investors compared Argentina to Mexico in 1995 (IMF 2003, p.38). Kassa (2004) argues that Argentinean government lost trust of the public before 1998 due to its history of inflation and recessions resulting from improper policy implementations. Kassa’s theory explains why investors fled as Asian markets entered a crisis. Moreover, demand for Argentinean exports diminished because of the US dollars depreciation. Solutions demanded a contractionary policy. Since the shock was to both, current account and capital account, solution needed to restore balance of payments. With a pegged exchange rate regime, Argentina needed to increase exports and decrease imports. In the absence of devaluation, the only way this was possible was through a decrease in consumption. Government expenditure decreased and taxes increased (Rodriguez – Boetsch 2005, p. 310). However, capital flight out of the country left Argentinean banks unprepared (Rodriguez – Boetsch 2005, p.310). Thus, riots occurred as consumers could not access their money. The labor market also needed to adjust in order to absorb the shock. The labor market could not absorb shocks and act as a replacement to the exchange rate. Labor market needs to be flexible in order for wages and employment to decrease so companies could remain profitable. However, Argentinean labor market remained quite rigid. Though Argentina experienced an increase in labor productivity in early 1990’s, central bargaining and rigidity of wages still remained quite strong by the 1998 (IMF 2003, p.27). Consequences reversed much of the progress from the 1990’s. Argentinean economy entered recession in the fourth quarter of 1998. The recession lasted until 2003, when growth was re – established. Decline of GDP was significant: in 1999, GDP declined by 3.5 percent, in 2000 by 0.5 percent, in 2001 by 5.5 percent, and in 2002 by 12.5 percent (Rodriguez – Boetsch 2005, p.309). Though Argentinean economy grew before 1998, years of stagnation reversed the progress by 2003. Finally, the peg was abandoned. By 2001, the crisis escalated. In 2002, Eduardo Duhalde became president of Argentina, who completely abandoned the peg. The Argentinean peso was allowed to depreciate. Since everything was valued in US dollars, this change in policy also implied a conversion of all prices, fees and contracts to pesos. In return, GDP increased and unemployment decreased. Since Argentina was also indebted, moratorium on repayments was imposed (Rodriguez – Boetsch 2005, p.313). The pegged exchange rate regime catalyzed the crisis, but it did not cause it. Lack of prudent fiscal policy, rigidities in the labor market as well as a history of bad decisions made Argentina fragile to external events in 1998. The pegged exchange rate regime caused dependence on foreign capital and eliminated monetary policy until the Convertibility Plan was abandoned. Had other policies been implemented, perhaps Argentina would have avoided such a collapse of their economy. References Gokbudak, N. 1995. ‘Monetary Multiplier and Monetary Control’ [Online] http://ideas.repec.org/p/tcb/dpaper/9505.html [6 march 2012] IMF. 2003. ‘Lessons from the Crisis in Argentina’ [Online] Available: http://www.imf.org/external/np/pdr/lessons/100803.pdf [6 March 2012] Kassa, K. 2004. ‘Learning, Large Deviations, and Recurrent Currency Crises,’ International Economic Review 45(1):141-173. Pink, B. 2004. Balance of Payments: Sources and Methods, Welington: Statistics New Zealand. Rodriguez – Boetsch, L. 2005. ‘Public Service Privatization and Crisis in Argentina’ Development in Practice 15 (3/4): 302-315. Read More